Interim Findings Report Top 100 Program (income tax)

July 2019

UNCLASSIFIED EXTERNAL

UNCLASSIFIED EXTERNAL 2

We are publishing our key findings from 80 tax assurance reviews which have been issued to help taxpayers understand how we apply the justified trust methodology to obtain greater assurance that large public and multinational taxpayers are paying the right amount of income tax or identify areas of tax risk for further action.

Top 100 engagement The Top 100 population consists of public and multinational businesses and superfunds that have substantial economic activity related to Australia. They form the largest contributors to corporate income tax, good and services tax (GST), excise, and petroleum resource rent tax (PRRT) collections. The largest 100 corporate groups reported $30.9 billion or 42% of all corporate income tax for the 2016-17 income tax year.

As the Top 100 can have a significant impact on the health of our tax system, we engage with them one-to-one to manage their compliance and assure their tax performance.

Top 100 taxpayers are initially identified based on the size of their Australian operations. Other factors we consider include income tax, GST or excise paid and the influence the taxpayer may have on their market segment. We review and moderate the Top 100 population annually.

Our approach

Justified trust is a concept from the Organisation for Economic Cooperation and Development (OECD).

The ATO introduced the justified trust concept starting with the Top 100 population in 2016. We have now completed and issued many of the first year tax assurance reports (TARs) for income tax.

The justified trust concept has expanded to GST for the Top 100 population.

We apply the justified trust methodology and seek to obtain assurance of the following four focus areas:

that appropriate tax risk and governance frameworks exist and are applied in practice

that none of the specific tax risks we have flagged to the market are present

the tax outcomes of atypical, new or large transactions are appropriate

any misalignment between tax and accounting results is explainable and appropriate and the right amount of tax on profit from Australian-linked businesses is being recognised in Australia.

This paper outlines our findings in respect of the four justified trust focus areas for income tax.

UNCLASSIFIED EXTERNAL 3

Overall levels of assurance The overall level of assurance is based on an objective view (having regard to objective evidence) of whether the taxpayer is considered to have paid the right amount of tax.

Ratings

We apply consistent rating categories when considering our overall level of assurance.

High We obtained assurance that the taxpayer paid the right amount of Australian income tax for the income year(s) reviewed. This means we are unlikely to contact you again in relation to the income year(s) reviewed unless something new comes to our attention.

Medium We obtained assurance in relation to some but not all areas reviewed. For those areas not yet assured, further evidence and/or analysis will be required before we obtain assurance that the taxpayer paid the right amount of Australian income tax for the income year(s) reviewed.

Low We have specific concerns around the taxpayer’s compliance with the Australian income tax laws and the amount of Australian income tax paid for the income year(s) reviewed.

The reviews completed to the end of June 2019 resulted in the following ratings:

Graph 1 - Overall assurance ratings1

1 The medium-high and low-medium ratings are unique to the Top 100 program. These ratings are not used in the Top 1000

program.

UNCLASSIFIED EXTERNAL 4

Graph 2 - Overall assurance rating by industry2

Observations

Most taxpayers reviewed obtained an overall medium assurance rating. This means we obtained assurance in relation to the majority of areas reviewed but not all areas. This reflects the complexity of large businesses.

The majority of the TARs issued up to the end of June 2019 are ‘first year’ TARs. This means that it is the first one for the taxpayer. Some ‘first year’ TARs will still be issued this year, but many Top 100 taxpayers can expect to receive their ‘second year’ TAR this year.

The Top 100 population are our largest taxpayers and we expected that it would take more than one year to review the entire business and attain high assurance. As a result we are expecting a material portion (approximately 35%) of Top 100 taxpayers to transition from medium to high assurance this year, with a greater proportion of Top 100 taxpayers forecast to attain high assurance in 2020. This assumes that Top 100 taxpayers provide the required objective evidence to support the high assurance outcome, and that we don’t identify any further issues in the review.

We are continuing to work closely with Top 100 taxpayers to attain a higher level of assurance as part of the yearly Pre-lodgment Compliance Review (PCR) and Annual Compliance Arrangement (ACA) processes. This is documented within each TAR, specifically in the personalised future assurance plan contained in section 1 of each report.

2 Overall assurance ratings for the most recent TAR issued. The industry groupings include: Banking, Finance and Investment,

Superfunds and Insurance (BFI), Manufacturing, Construction and Agriculture (MCA), Mining, Energy and Water (MEW),

Wholesale, Retail and Services (WRS).

UNCLASSIFIED EXTERNAL 5

Tax risk management and governance We consider the existence, design and operation of a tax control framework for income tax focusing on the six controls set out in the director's summary in the Tax risk management and governance review guide (the Guide).

The Guide sets out principles for board-level and managerial-level responsibilities, with examples of evidence that demonstrates the design and operational effectiveness of tax control frameworks. The Guide focuses on the processes and controls in place and may not necessarily reflect the tax risk appetite or capabilities and experience of the tax or finance team, or their advisors.

Ratings

We apply a consistent rating system when reviewing and assessing tax governance. Practical guidance about how we rate tax governance is available on ato.gov.au3.

Stage 3 You provided evidence to demonstrate that a tax control framework exists, has been designed effectively and is operating effectively in practice.

Stage 2 You provided evidence to demonstrate that a tax control framework exists and has been designed effectively.

Stage 1 You provided evidence to demonstrate a tax control framework exists.

Not evidenced or concerns

You have not provided sufficient evidence to demonstrate a tax control framework exists or we have significant concerns with your tax risk management and governance.

The reviews completed to the end of June 2019 resulted in the following ratings which have been grouped by industry:

3 https://www.ato.gov.au/business/large-business/compliance-and-governance/reviewing-tax-governance-for-large-public-and-

multinational-businesses

UNCLASSIFIED EXTERNAL 6

Graph 3 - Overall governance rating by industry4

Observations

In our reviews we require board endorsed tax control framework documentation and focus on the following six controls set out in the Guide which are aligned with the following justified trust objectives:

understanding an entity’s tax control framework

­ Board-level control 4: Periodic internal control testing

­ Managerial control 1: Roles and responsibilities are clearly understood

­ Managerial control 6: Documented control frameworks

identifying risks flagged to the market

­ Board-level control 3: The board is appropriately informed

understanding significant and new transactions

­ Managerial control 3: Significant transactions are identified

understanding why the accounting and tax results vary

­ Managerial control 7: Procedures to explain significant differences

Tax governance is a key focus area under the justified trust methodology for large public and multinational businesses. We are working with our Top 100 taxpayers to understand how their tax governance is reflected in positions taken, disclosures in returns, and tax calculations. A stage 2 rating is required to achieve a high assurance overall rating. This means taxpayers have provided evidence to demonstrate that a tax control framework exists and has been designed effectively.

A robust tax governance framework that is designed and operating effectively gives us greater confidence in the reported tax outcomes. We are seeing an investment in tax governance and this is reflected in our findings that the majority of the Top 100 have robust

4 Overall governance rating for the most recent TAR issued. The industry groupings include: Banking, Finance and Investment,

Superfunds and Insurance (BFI), Manufacturing, Construction and Agriculture (MCA), Mining, Energy and Water (MEW),

Wholesale, Retail and Services (WRS).

UNCLASSIFIED EXTERNAL 7

governance, or are taking steps to improve their tax risk governance and are using the ATO guidance. We will continue to work with our Top 100 taxpayers as they enhance and finalise this process.

Stage 1

We have seen that most Top 100 taxpayers have provided evidence of a tax control framework. A stage 1 rating reflects that further work is needed to practically demonstrate that the framework is designed effectively. Many Top 100 taxpayers are currently formalising and documenting their tax control frameworks and/or providing objective evidence to evidence that their tax control framework meets the designed effectively criteria. We are currently working with Top 100 taxpayers with a stage 1 rating to progress to a stage 2 rating as part of the next TAR.

We are seeing in some instances taxpayers are presenting evidence of a tax control framework by way of ‘advisory’ letters. This is not a substitute for the objective evidence that is needed to demonstrate there is a tax control framework in place.

Stage 2

For stage 2, we look for objective evidence that the tax control framework is designed effectively. We are seeing more taxpayers undertaking a gap analysis and presenting this to us during the review. We have two observations regarding the gap analysis.

Where gaps have been identified and changes are recommended in the gap analysis report, to obtain stage 2, we need to see that these recommended changes have been implemented. Alternatively, we need to see a description of compensating controls and/or documentation setting out why particular aspects of the Guide may not be applicable to the taxpayer’s circumstances.

The gap analysis report provided to us needs to include references to the document names of the policies/procedures which were reviewed and relied upon as evidence in conducting the gap analysis (and these documents should be provided with the gap analysis report).

Stage 3

To obtain a stage 3 rating we look for evidence that the documented tax control framework is both designed and operating effectively in practice. While a small number of taxpayers have achieved a stage 3 rating to date, we are working with a broader group to improve their rating and achieve a stage 3 rating.

This stage requires evidence in the form of a report of findings that taxpayers have independently tested the operation of the framework in practice. The internal audit function is independent and can undertake the testing, as they report to the audit committee rather than to management (and are therefore independent to, and separate from the tax function).

The report of findings should conclude that the documented tax control framework is operating effectively. Where improvements or enhancements are recommended, we will seek to understand whether these are (or will be) implemented.

Red flag

A red flag rating is only applied after careful consideration where we have significant concerns with the taxpayer’s tax control framework as evidenced by the high level of errors identified and/or fundamental concerns about the robustness of existing tax controls.

UNCLASSIFIED EXTERNAL 8

Not rated

This rating has been applied in the Top 100 program in a very small number of cases. The reasons for this vary but include large scale mergers and acquisitions, and also where the tax control framework was being substantially redesigned (and the changes were so significant that it was appropriate to defer the assessment to the following year).

UNCLASSIFIED EXTERNAL 9

Tax risks flagged to market / Significant and new transactions and specific tax risks We seek to understand and review the income tax treatment of the taxpayer’s business activities, particularly significant and new transactions. We also look for and review risks or concerns communicated to the market and determine if they are present.

Ratings

We apply a consistent rating system when reviewing and assessing the income tax treatment of taxpayer’s business activities including significant and new transactions and tax risks communicated to the market.

High We obtained a high level of assurance that the right Australian income tax outcomes were reported in your income tax return(s). This means we are unlikely to contact you again in relation these matters for the income year(s) reviewed unless something new comes to our attention.

Medium More evidence and/or analysis is required to establish a reasonable basis to obtain a high level of assurance.

Low More evidence and/or analysis is required to determine whether a tax risk is present.

Red flag Likely non-compliance with the income tax law.

- Out of scope We have not evaluated this item and not expressed a rating.

Observations

Our assurance reviews will cover a number of areas which range from significant transactions and items in the tax return to specific risks either identified in the tax return or communicated to the market. In our reviews we consider all relevant Taxpayer Alerts and Practical Compliance Guidelines (PCGs) to assess whether they apply to the taxpayer’s particular circumstances. We also review Reportable Tax Position Schedule disclosures.

The assurance areas covered in the analysis for tax risks flagged to market, and significant and new transactions often have material tax consequences if they have been incorrectly treated or calculated for tax. Typically this is where most of our time during the review is spent to obtain higher levels of assurance. This also has the greatest impact on the overall assurance ratings depicted above.

In the past 12 to 18 months we have issued more than 20 new tax alerts, PCGs and relevant public rulings to address strategic tax risks and areas of concern. Several Top 100 taxpayers have arrangements that are covered by a guidance or advice product and we are working with these taxpayers to move away from any high risk arrangements. In many cases, there is more evidence or work needed to be able to assure that the arrangement or transaction has been reported correctly and the right amount of tax has been paid. It is therefore expected the ratings for these areas will improve over time as the assurance review is completed or, if there is a dispute underway, it is resolved.

UNCLASSIFIED EXTERNAL 10

Transfer pricing

Transfer pricing is a common assurance area with approximately 85% of Top 100 taxpayers reporting related party dealings. This area encompasses a substantially large number of dealings and they can range from simple to very complex in nature.

The following is a breakdown of the typical transfer pricing areas reviewed:

Adequacy of information available to support transfer pricing positions

Inbound and outbound supplies of goods and services

International related party financing

­ Interest free loans outbound and inbound

­ Cash pooling arrangements

Management & administrative services

Licence fees and royalties

Technical services

R&D performed on behalf of overseas related party

Sale or use of Australian intangible assets overseas (including failure to adequately recognise use of Australian assets)

Offshore hubs or service centres

Common issues arising in relation to transfer pricing analyses include:

The size and complexity of the global value chain in the Top 100 population - The Top 100 often have very complex businesses and Australia can be a significant part of the value chain. We are finding this takes time to source relevant information to support the transfer pricing analysis.

Changes in transfer pricing policy / methodologies without an underlying change to taxpayer functional analysis.

Related party financing transactions - Top 100 taxpayers generally have at least one

financing related issue that has been reviewed. Where applicable, we would expect to see evidence supporting a Top 100 taxpayer’s self-assessment of the risk indicators and risk zone rating pursuant to PCG 2017/4. High quality documentation is also expected to be maintained to support transfer pricing positions and debt allocations with respect to financing related income or deductions.

In relation to services transactions, the beneficial nature of services and

appropriateness of allocation keys is not well documented or evidenced.

In relation to royalty / licensing / intellectual property arrangements, the performance

of development, enhancement, maintenance, protection and exploitation activities is not well documented or evidenced.

Where transactions are covered by an Advance Pricing Arrangement (APA) or Bilateral Advance Pricing Arrangement (BAPA), we will review the agreement/s and the annual compliance report that is required to be submitted annually for APAs and BAPAs to ensure that taxpayers are continuing to follow the terms of the agreement/s. Where transactions are subject to settlement agreements or private rulings we also review these to confirm that taxpayers are adhering to the terms of the settlement agreement, or implementing the relevant transactions in accordance with the ruling.

UNCLASSIFIED EXTERNAL 11

Structured arrangements designed to reduce Australian tax In some cases, we see arrangements that are structured to reduce Australian tax. In those cases, the low assurance ratings and red flags are sometimes associated with related party transactions (including third party back-to-back transactions) promoted or designed to achieve Australian tax savings including:

Related party financing transactions with special terms designed to:

­ Defer or eliminate withholding tax while preserving annual Australian income tax deductions

­ Achieve cross-border hybrid mismatch outcomes (e.g., double deductions or deductions with no corresponding income), and/or

­ Circumvent specific anti-avoidance rules such as thin capitalisation and debt/equity classification rules.

Changes in membership of Australian tax groups through internal transactions or decisions designed to:

­ Increase or accelerate deductible losses or depreciation

­ Generate Australian tax deductions for anticipated asset write offs

­ Avoid tax on anticipated terminations or disposals, and/or

­ Generate foreign tax credits.

Migration of Australian generated intangible assets to overseas related parties in order to reduce Australian taxable income.

Interposing partnerships or other entities designed to:

­ Shift recognition of income and/or change the nature of income

­ Reduce or eliminate withholding tax, and/or

­ Avoid the application of targeted anti-avoidance measures.

Other common areas attracting our attention

Other areas that commonly arise in reviews that attract our attention include:

Consolidation – consolidation areas reviewed include the Allocable cost amount (ACA)

process (we have seen some instances where the ACA has not been prepared at the time of the assurance review), asset recognition, valuation and MEC groups.

R&D expenditure – this area is a particular focus of the ATO and a number of different taxpayer alerts have been issued in relation to eligibility of R&D activities and expenditure respectively. We are commonly asking for more detailed working papers for R&D expense allocations and overheads. In some instances, we have also referred R&D matters to AusIndustry for a review of the eligibility of R&D activities, particularly in relation to software development and digital transformation activities.

Thin capitalisation – some of the issues we are seeing are asset revaluations and not including some arrangements as debt such as preference shares and notes.

Losses – we holistically focus on generation, carry forward, transfer and utilisation of any

losses. Our reviews consider not only the technical tax analysis but we also look to understand the origin of the losses and the commercial environment of the business at the time they were incurred. We also seek to understand when Top 100 taxpayers will utilise any carry forward losses and move into a tax payable position.

UNCLASSIFIED EXTERNAL 12

Uniform capital allowances – this is usually a large area of assurance for capital intensive Top 100 taxpayers as they own a high percentage of fixed assets (property, plant and equipment). We are seeing instances of the incorrect application of effective lives, incorrect calculations and accelerated depreciation . We also have concerns with the use of automated software where the outcomes may not be compliant with the law, the incorrect use of project pools, and the incorrect treatment of balancing adjustments on disposals. It is important that there are appropriate internal systems and good governance practices to record assets, and to calculate effective lives and depreciation. We will ask to see the tax fixed asset register and the working papers, and we will also verify original cost and adjustable values for high value assets.

Deductions – most of the general deductibility issues we are seeing relate to revenue or capital classification and the subsequent tax treatment of the expense. This includes capitalised labour, exploration expenses and repairs and maintenance.

Revenue – we are seeing that in some cases we need more evidence and/or analysis of

sales revenue and other material revenue amounts to establish a reasonable basis to obtain a high level of assurance where we have been unable to reconcile revenue figures reported in the tax return with audited financial accounts.

Controlled foreign companies, related party derivatives and attribution of profits to permanent establishments – are also areas that commonly arise in our justified trust reviews.

Ratings and engagement

For some issues or transactions we require more evidence and/or analysis to obtain high assurance. We are working with Top 100 taxpayers to articulate the areas that require further evidence or analysis. In some cases medium assurance ratings on specific transactions may be satisfactory and, depending on the area and the significance of the transaction, it may still be possible to achieve high assurance overall.

High quality information, relevant supporting documentation, and an open and transparent relationship with the ATO are expected from taxpayers to be able to achieve high assurance.

UNCLASSIFIED EXTERNAL 13

Alignment of tax and accounting outcomes We analyse the differences between the accounting and tax results. This includes understanding the effective tax rates and effective tax borne (ETB). We seek to understand and be able to explain any variances between tax and accounting outcomes. This provides an objective basis to obtain greater assurance.

Ratings

We apply a consistent rating system when reviewing and assessing the alignment of tax and accounting outcomes, which is outlined below.

High We understand and can explain the various streams of economic activity and why the accounting and income tax results vary.

Medium Further analysis and explanation is required to understand the various streams of economic activity and/or why the accounting and tax results vary.

Low We identified concerns from our analysis of the various streams of economic activity and/or why accounting and tax results vary.

Red flag We do not understand and cannot explain the various streams of economic activity and/or why accounting and tax results vary.

The reviews completed to the end of June 2019 resulted in the following ratings:

Graph 4 – Alignment of tax and accounting ratings

UNCLASSIFIED EXTERNAL 14

Observations

Most (85%) of the Top 100 has obtained a medium to high assurance rating with respect to the alignment of tax and accounting outcomes. We generally are able to obtain a good level of assurance over reported income and expenses as most taxpayers have audited financial statements and we are able to review the reconciliation between financial statements with the starting profit and loss disclosed in the relevant tax return. This is more challenging for Multiple Entry Consolidated (MEC) groups, foreign bank branches and stapled groups. We are also generally seeing good procedures for calculating taxable income from accounting results.

The large number of medium ratings (49%) for this focus area is demonstrative of the further analysis that is currently underway to understand the various streams of economic activity and where the accounting and tax results vary for the Top 100 population. It is also due to the significance of the business and complexity of transactions that are still being reviewed and have not yet been rated as high assurance.

It is also representative of the number of MEC groups, foreign branches and stapled groups that are in the Top 100 population. Without the reconciliation between audited financial statements and the starting profit and loss disclosed in the relevant tax return, significant more work is required to be able to evidence that the tax return items and book to tax adjustments are correct. We are working with these groups to review the bridging reconciliation to be able to increase the assurance rating.

Another element of this section is to undertake an ETB calculation. This is an approach to analyse the tax and economic performance of corporate groups. We consider that ETB is a part of good governance. Boards and tax representatives of corporate groups should understand their ETB calculation and discuss the results (and confirm the assumptions and proxies that have been used) particularly around the global value chain and foreign taxes paid on Australian linked activity with the ATO. We encourage taxpayers to undertake and maintain the ETB calculations and then present and discuss with the ATO their results and explain what inputs went into the calculation.

Tailored high assurance engagement

Obtaining High Assurance

In the Top 100 program, we apply a principled approach to reaching overall high assurance. This is based on two elements, first, a quantitative threshold of more than 90% tax assured / economic activity correctly reported, and second, an objective assessment of seven qualifying factors. The seven qualifying factors are outlined below:

Qualifying Factors:

1.Governance

Governance has been rated at least a stage 2 in the TAR.

2. Tax risks flagged to market

Any tax risks flagged to market (PCGs, tax alerts, public rulings, including those set out in the RTP Category C disclosures) have been rated at least a medium level of assurance in the TAR and are not also identified as warranting further action which has been captured in the Future Assurance Plan.

UNCLASSIFIED EXTERNAL 15

3. International related party Dealings and CFC’s

International related party dealings, profit attribution to permanent establishments and CFCs have received at least a medium level of assurance in the TAR and are not also identified as warranting further action.

4. Losses

Losses, if applicable, have received at least a medium level of assurance in the TAR. This includes that the commerciality of tax losses has been verified and we understand when a taxpayer will utilise carried forward balances and move into a tax payable position.

5. Effective Tax Borne (ETB)

The ETB calculation in the TAR and any underlying assumptions or proxies have been verified with the taxpayer. The ETB calculation has not highlighted any new areas of concern for us, including, for example, the use of tax havens where there is not a substantiated commercial purpose.

6. Reportable tax position schedule

There are no inconsistencies in RTP schedule disclosures which are identified between lodgment of the tax return and finalisation of the TAR.

7. Cooperative and collaborative behaviour

It has been a cooperative and collaborative process, and working with a taxpayer we have not observed any non-cooperative behavior.

A provisional high assurance (justified trust) rating may still be possible where there is

ongoing compliance activity depending on the nature and stage of the compliance activity and provided the quantitative threshold is met (inclusive of that unassured issue). If you have on-going compliance activity in relation to an issue covered by the qualifying criteria, it is recommended that you engage with your senior relationship manager to discuss the potential impact on your ratings.

High assurance approach

Reaching high assurance under the justified trust approach will generate a tangible change in the client experience to recognise the trust we have that the right amount of Australian income tax is being paid. The depth of engagement we have with Top 100 taxpayers in a PCR will vary between years based on whether justified trust is being relied upon, verified or refreshed.

For Top 100 PCR taxpayers that obtain high assurance, we will continue to monitor their tax outcomes over the next two income tax years to maintain the level of justified trust obtained. We will be using our data and analytics capability to monitor income tax returns and other information reported, and will be verifying any new or significant transactions or new tax risks flagged to market. We will expect taxpayers to notify us of new transactions or significant changes as soon as they are known. The table below represents what the monitoring and maintenance cycle may look like for a PCR taxpayer.

UNCLASSIFIED EXTERNAL 16

Rely Verify Refresh

We trust the taxpayer will tell us and their tax governance will effectively identify new tax positions, errors and new transactions.

We require evidence to verify new transactions or significant changes.

We resume our usual intensity to refresh our confidence and maintain high assurance.

We will usually undertake a justified trust review to refresh our confidence in a taxpayers tax outcomes every third year. The refresh year will comprise a review of the four focus areas of the justified trust methodology and a new TAR report issued for that income tax year. We will leverage the earlier justified trust work to undertake the refresh. We may undertake a refresh earlier than the third year if there has been a significant business change that affects the majority of the taxpayer’s business for example, a merger etc., or we have reason to believe that our trust should no longer be maintained.

For Top 100 ACA taxpayers who have obtained a high overall level of assurance we will continue to do an ACA review annually, including an ETB analysis. There will be no additional justified trust reviews for the next two income tax years. We will resume our usual intensity in our ACA reviews to refresh our confidence and maintain high assurance every third year.

Other materials Our Tax and Corporate Australia5 publication available on our website provides details on ways we’re improving the system for those who want to comply, and how we're taking firm action against those who choose not to. The publication also aims to provide an increased understanding of how Australia's tax system is operating for the largest corporations.

5 https://www.ato.gov.au/General/Tax-and-Corporate-Australia/

ato.gov.au